If you are a new business owner, you have undoubtedly already tackled many decisions regarding your company operations. However, one of the most impactful choices to make is whether you should use the cash or accrual accounting method. Since this decision affects everything from financial reports to tax filing, you should understand the differences and advantages of both before you decide.
What’s the Difference?
The difference in cash accounting vs. accrual accounting is simply the timing of when transactions are recognized. In cash accounting, income and expenses are recorded only when money changes hands (e.g., when a customer pays or when you pay for supplies). On the other hand, the accrual method accounts for income at the time work is performed and expenses supplies when they are acquired, regardless of when money is exchanged.
For example, take a contractor who completes a $10,000 job in July, but is not paid until August. With the cash method, he would record his income in August, when he received payment; with the accrual method, he would record it in July when he invoiced the work.
Advantages and Disadvantages
The biggest advantage to cash accounting is that it’s simple. You always know how much actual cash your business has. The disadvantage though, is that it shows inaccurate profits and losses month-to-month. Let's say our contractor, for example, spent $2,000 on supplies for that $10,000 job. So July’s income report will show a negative cash flow of $2,000, while August’s will show a $10,000 profit. In this way, cash accounting doesn’t reflect an accurate overall picture of a company’s net revenue.
With accrual accounting, the opposite is true. Since both income and expenses for a job or service are recorded when the work is done, you get a more realistic picture of your profit margins. It’s also easy to see what payments are expected down the road, which helps with budgeting and planning. The downside to the accrual method is you must pay careful attention to your cash flow. You may have thousands of dollars out in invoices, but an empty bank account as you wait for your customers to pay you.
Speaking of waiting for customers to pay, with the accrual method, you must stay on top of your payment collections process. If you don’t, you may end up paying taxes on income that you never actually received. It’s critical that your bookkeeper review remaining unpaid invoices at the end of the year and write off any determined as uncollectible, so that you don’t pay unnecessary income taxes.
Which Method is Right for You?
When it comes to deciding between cash accounting vs. accrual accounting, the IRS has some specific rules on the matter. Basically, they are fine with anyone using the accrual method, but to use the cash method, you must meet certain criteria regarding structure, income, and other factors.
The accrual accounting method is more commonly used, largely because you never have to worry about outgrowing your accounting method. It's burdensome to start out using cash accounting, then have to switch over to the accrual method due to increased sales or a change in your business structure.
For small proprietors and freelancers, however, the simplicity of cash accounting is appealing and perfectly effective. Small service businesses such as consultants, caregivers, handymen, real estate agents and other professionals who sell their time and not a product, are also good candidates for cash accounting.
Need Help Deciding?
Think about the size and type of your business and your growth potential and goals, and review the IRS guidelines in the link above. Still can't decide? We can help!